In this article, we will estimate the intrinsic value of Cummins India Limited (NSE: CUMMINSIND) by taking expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.
There are many ways that businesses can be assessed, so we would like to stress that a DCF is not perfect for all situations. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.
Check out our latest review for Cummins India
Step by step in the calculation
We use the 2-step growth model, which simply means that we take into account two stages of business growth. In the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
In general, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year free cash flow (FCF) forecast
|Leverage FCF (₹, Millions)||₹ 3.32b||₹ 8.40b||₹ 10.8b||₹ 13.1b||₹ 15.4b||17.6b||₹ 19.7b||21.7b||23.7b||25.8b|
|Source of estimated growth rate||Analyst x1||Analyst x1||Est @ 28.33%||Est @ 21.85%||Est @ 17.32%||Est @ 14.14%||Est @ 11.92%||Est @ 10.37%||East @ 9.28%||Est @ 8.52%|
|Present value (₹, Millions) discounted at 13%||₹ 2.9k||₹ 6.5k||₹ 7.4k||₹ 8.0k||₹ 8.3k||₹ 8.3k||8.2k||₹ 8.0k||₹ 7.7k||₹ 7.4k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = ₹ 73b
The second stage is also known as terminal value, this is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used that cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (6.7%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 13%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = ₹ 26b × (1 + 6.7%) ÷ (13% – 6.7%) = ₹ 421b
Present value of terminal value (PVTV)= TV / (1 + r)ten= ₹ 421b ÷ (1 + 13%)ten= 121b
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is ₹ 194b. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of 885, the company appears to be slightly overvalued at the time of writing. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Cummins India as a potential shareholder, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which takes debt into account. In this calculation, we used 13%, which is based on a leveraged beta of 1.049. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
To move on :
While a business valuation is important, it shouldn’t be the only metric you look at when researching a business. The DCF model is not a perfect equity valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. Why is intrinsic value lower than the current share price? For Cummins India, we have compiled three relevant factors that you need to assess:
- Risks: You should be aware of the 1 warning sign for Cummins India we found out before considering an investment in the business.
- Future benefits: How does CUMMINSIND’s growth rate compare to that of its peers and the wider market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
PS. Simply Wall St updates its DCF calculation for every Indian stock every day, so if you want to find the intrinsic value of another stock just search here.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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